Do you 'really' know your home loan?

Purchasing a house probably qualifies as the single largest buying decision that an individual makes in his life. That's why care needs to be taken while planning for finances while arriving at this decision.

Understanding the tax implications as well as the 'real rate of borrowing' of a home loan helps the individual in evaluating his options better.

Budget 2005 provided a stimulus to the home loan industry. It increased the tax benefits (i.e. deduction) available on the principal portion of the annual home loan EMI (equated monthly instalments) to Rs 100,000. Earlier, it stood at Rs 20,000.

In other words, up to Rs 100,000 of the principal amount repaid on home loans every year would be allowed as a deduction under Section 80C from the taxable income for that year.

In addition to the principal, home loan interest also attracts tax benefits in the form of a deduction under Section 24. Interest paid up to Rs 150,000 per year is allowed as a deduction from taxable income. An illustration will help in understanding this better.

Know your home loan break-up

Year 1

Year 2

Year 3

Year 10

Year 19

Home Loan amount (Rs)

700,000

Rate of interest

8%

Tenure (Yrs)

20

Annual EMI amount (Rs)

70272 (Rs 5,856 p.m. x 12 months)

Interest component (Rs)

55,464

54,236

52,905

39,924

8,074

Principal component (Rs)

14,808

16,036

17,367

30,348

62,198

Suppose an individual with an annual income of Rs 300,000 decides to opt for a home loan worth Rs 700,000 for a 20-year tenure. The home loan interest rate is assumed to be 8%. The EMI for this loan works out to Rs 5,856 p.m. This means that the individual pays Rs 70,272 as EMI every year (i.e. Rs 5,856 x 12 months).

As the table shows, in the first year, the interest component in the EMI is Rs 55,464 and the principal amount constitutes the remaining Rs 14,808. As per Section 80C, the principal amount worth Rs 14,808 is allowed to be deducted from the individual's income of Rs 300,000 as a 'deduction.' The interest component of Rs 55,464 is also allowed as a deduction under Section 24.

It can also be seen that though the EMI remains the same throughout the tenure, the interest and the principal components, which form the EMI, keep changing every year. For example, the interest component for the second year is Rs 54,236 and the principal is Rs 16,036.

Individuals should note that the interest component is high in the initial few years after which it reduces significantly in the later period.

Individuals also need to know the 'effective cost of borrowing a home loan' after factoring in the tax benefits. The rate of interest mentioned in the illustration above is 8%. However, if the tax benefits were to be accounted for, then the effective rate would be much lower. An illustration would make things easier to understand.

Time to get 'real'

YEAR 1

YEAR 2

Tax brackets (%)-(A)

10.20

20.40

30.60

10.20

20.40

30.60

Home loan amount (Rs)- (B)

700,000

700,000

Total annual EMI (Rs)- (C)

70,272

70,272

Interest amt (Rs)- (D)

55,464

54,236

Principal amt (Rs)- (E)

14,808

16,036

Averaged principal paid (Rs)- (F)

7404 (i.e. 14,808/2)

22,826 (i.e. Rs 14,808 + Rs 8,018)

Averaged annual outstanding loan amt (Rs)- (G = B - F)

692,596

677,174

Tax saved on interest paid (Rs)- (H)

5,657

11,315

16,972

5,532

11,064

16,596

Effective interest paid (Rs)- (I = D - H)

49,807

44,149

38,492

48,704

43,172

37,640

Effective interest rate (%)- (J = I/G X 100)

7.19

6.37

5.56

7.19

6.38

5.56

Tax saved on principal paid (Rs)- (K)

1,510

3,021

4,531

1,636

3,271

4,907

Real interest paid (Rs) (L)

48,296

41,129

33,961

47,068

39,901

32,733

Effective cost of borrowings (%)- (M = L/G X 100)

6.97

5.94

4.90

6.97

5.94

4.90

As already mentioned earlier, the loan amount is Rs 700,000 borrowed at an 8% rate of interest for a 20-year tenure. The total annual EMI is also same at Rs 70,272. The interest component for the first year is Rs 55,464.

Assuming that the individual falls under the 30.6% tax bracket, the tax saved on the interest paid for the first year is Rs 16,972 (i.e. 30.6% of Rs 55,464). Due to the tax saved, the effective interest paid works out to Rs 38,492 (Rs 55,464 - Rs 16,972).

This brings the effective interest rate down to 5.56% (calculated as a percentage on the averaged outstanding loan amount, i.e. Rs 692,596 for the first year).

However, to calculate the effective rate of borrowing, the individual would also need to account for the tax saved on the principal component. In this example, the tax saved on the principal amount of Rs 14,808 is Rs 4,531 (i.e. 30.6% of 14,808).

This amount of Rs 4,531 has to be removed from the effective interest paid to arrive at the real cost of the loan. This works out to Rs 33,961 (Rs 38,492  Rs 4,531). Calculated as a percentage on the averaged outstanding loan amount (of Rs 692,596), the effective cost of borrowings now works out to 4.90%!

Individuals who fall in the 10.2% and the 20.4% tax bracket can follow this exercise of calculating the interest rate and cost of borrowings as well. The same exercise can be followed to calculate the rates for the following years too.

As can be seen from the table however, the 'effective interest rate' as well as the 'effective cost of borrowings' will remain the same throughout the tenure. This is due to the fact that the tax benefit on interest paid as well as principal repayment is the same (the constitution of the EMI therefore does not impact overall tax benefit).

Individuals need to bear in mind the actual costs of borrowing on a home loan. As explained above, the actual cost of borrowing turn out to be lower than the rate at which a housing finance company has given the home loan. Individuals also need to keep in mind the changing principal and interest components every year. This will help them in their tax planning exercise with respect to investments in other tax-saving avenues falling under the Section 80C gamut.

Some figures in the tables given above have been rounded off for ease of calculations.